IMF calls for ruthless action over China’s corporate debt

As non-performing business loans hit 145% of GDP, IMF first deputy director David Lipton puts forward a three-step remedy

China must tackle its corporate debt levels without delay, or risk further economic struggles, International Monetary Fund (IMF) first deputy director David Lipton has warned.

In an 11 June speech in Shenzhen, Lipton said that the country’s ongoing problem with non-performing loans (NPLs) goes against the grain of the IMF’s recent decision to include the renminbi in its basket of reserve currencies.

While acknowledging China’s “moderate” success with reorienting its economy from investment to consumption, Lipton criticised the government’s “limited progress” on corporate debt, describing the issue as a “key fault line in the Chinese economy”.

Lipton pointed out that total debt in China is equal to about 225% of GDP. Of that, government debt represents about 40%, while households account for a similar proportion. By international standards, he said, neither of those burdens are particularly high.

However, he stressed: “Corporate debt is a different matter: about 145% of GDP, which is very high by any measure.”

By IMF calculations, Lipton noted, state-owned enterprises (SOEs) account for about 55% of corporate debt – far greater than their 22% share of economic output.

“[State-owned enterprises] are also far less profitable than private enterprises,” he said. “In a setting of slower economic growth, the combination of declining earnings and rising indebtedness is undermining the ability of companies to pay suppliers or service their debts. Banks are holding more and more NPLs.”

He added: “The past year’s credit boom is just extending the problem. Already, many SOEs are essentially on life support. [Our] most recent Global Financial Stability Report estimated that the potential losses for Chinese banks’ corporate loan portfolios could be equal to about 7% of GDP.

“This is a conservative estimate based on certain assumptions about bad-loan recoveries and excluding potential problem exposures in the ‘shadow-banking’ sector.”

Lipton recommended that regulators should adopt a three-step plan to combat corporate debt:

  1. Act quickly and effectively, or the problem will only worsen. “Company debt problems today can become systemic debt problems tomorrow. Systemic debt problems can lead to much lower economic growth, or a banking crisis. Or both.”
  2. When acting, deal with both creditors and debtors. “Some countries have just moved bad loans off bank balance sheets and recapitalised the banks. Companies were left unprofitable. Others have downsized companies or allowed them to go under. Banks were left undercapitalised. It is best to fix both.”
  3. Address the governance problems in the corporate and banking sectors that gave rise to the problem in the first place. “Otherwise, deflating the debt bubble will bring only temporary effect. A new debt bubble will surely re-inflate if unwarranted lending and borrowing can just resume.

Lipton also urged authorities to think carefully about a planned series of debt-for-equity swaps (recently covered in The Treasurer), saying that the initiative will work only if two conditions are fulfilled:

“First, banks need to be able to assert creditor rights and conduct a triage, distinguishing non-viable firms that need to restructure or shut down. Otherwise the new equity will have no value.

“Second, banks need the capability to either manage their equity and assert shareholder rights, or… to sell equity to investors who can.”

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